By Frederic Zana, Head of Capital Steering, Credit Agricole.
Frederic, can you please tell the Risk Insights readers a little bit about yourself, your experiences and what your current professional focus is?
I have been following regulation for 15 years with Basel 2, Basel 2.5, Basel 3 and now Basel 4, with many improvements in risk measurements, and a sharp increase of the number of prudential ratio to monitor. Basel 2 has introduced operational risk, Basel 2.5 has improved the treatment of credit risk for the trading book portfolio, Basel 3 has introduced liquidity and leverage measures and has increased the quality of own funds.
Part of the complexity that was the source of innovation in risk management under Basel 1 or 2 is now directly included in the pillar 1 measures of Basel 3, where at the same time pillar 2 has been increasingly formalized which reduces the incentives for innovation. This evolution has dramatically changed the way pillar 2 was managed. Under Basel 1 or 2 the focus was on all sorts of credit risks, crossing several sources of information from markets (spreads, PD estimated from Equity values, concentration effects measured in the bank portfolio, sectorial correlation and trends) in order to use market information to anticipate and manage credit risk or market risk. It has not always been very successful; markets are usually very poor at anticipating from a risk point of view.
Basel 3 and CRR have increased the search for new risks within pillar 2, which has led to a widen approach to risk anticipations: banks need to put in place risk identification processes on a very large number of potential risk which also lead to some sort of standardization of the risk measure in itself. Economic risk measures and pricing models are no more the main focus of pillar 2. Pillar 2 now focuses on what is missing in the risk management to anticipate what could go wrong. Especially, under Basel 2 economic capital was a source of loan pricing. More and more we are moving from economic measures to backstop measures, which can be reassuring for the regulator but which is a real problem in order to define the pricing of a transaction. Although the crisis brings examples of sudden default of highly rated companies (such as former AAA AIG), an overreaction of regulators now leads to a real change in incentives.
The reduction of risk sensitivity that is the essence of Basel 4 will lead to a change in the management of the balance sheet. As a matter of fact, regulation can be self-fulfilling: with MREL and leverage ratio, two non-risky ratio more and more binding, and now an output floor on the standard measure, it is a strong incentive to move some assets out of the balance sheet: high quality assets will be better off in the portfolio of asset managers rather than in banks’ portfolio. I expect banks to spend more and more time on the identification of pools of assets that are too costly to be financed by CET1 estimated with the output floor, AT1 for the leverage ratio, T2 capital and bail-inable debt (Senior Non preferred) for the TLAC and MREL measure… where backstop measures lead to stop loss measures!
At Risk EMEA 2018, you will be speaking on your insight regarding ‘Incorporating recovery and resolution planning into a broader framework to identify and manage liquidity and capital events’. Why is this a key concern right now? And what are the essential things to remember?
Recovery and resolution is a burning issue. BRRD had planned the first MREL targets by 2016, but the process has been delayed with the discussions on BRRD2. Now the whole process is maturing, several resolution in Italy have been transformed into case studies that have help improve the calibration of the requirements. Banks now have a good idea of the level of own funds and of eligible liability that they need to issue to reach the MREL/TLAC targets. Most jurisdictions now have defined the legislative framework to issue senior debt eligible to those measures, with a large space given to Senior Non preferred debt that is the cheapest subordinated TLAC eligible debt. Now is the time to focus on the planning of issuances and the cost optimization of subordinated resources.
How can firms effectively improve crisis management practices?
Crisis management practices can certainly be improved through the exchange of information. The publication of the resolution strategy for Italian banks provides some insights about the tools that can be used. There are maybe three areas that banks should focus on.
The first one is the detailed examination of contracts of debt issuances and of all liabilities in order to make sure that they will all be effective without risk of contestation. Third country issuances will have to include contractual recognition of bail in power to the home country. A detailed classification of all liabilities is necessary.
The second one is the constant practice of buy and sell of small entities. For large banks this is important in order to maintain a foot in reality and to make sure that there is a constant contact with markets, delays needed to sell an entity and to foresee potential shortcomings that needs to be solved in order for the resolution plan to be credible.
The last one is to define also a constant flow of asset sell, repo, or other transactions. It is necessary in order to make sure that the bank maintains a constant access to various sources of liquidity, and is able to remove assets from its balance sheet when needed, either through asset sale, securitization, or just using repo.
All this framework will be included in the governance, which make sure that all decision tools are in place when needed, and can be efficiently activated.
What are the key elements to consider when reviewing internal governance for recovery and resolution planning?
The most important element to consider is to ensure a proper validation of delegation for a transfer of capital between entities. Capital increase in some countries need to be validated by a resolution voted at a general meeting of shareholders, and all appropriate delegation must be put in place in order to be able to apply the recovery plan. The general management must also validate the recovery plan, and a set of triggers and alerts must also be defined and implemented. This is very similar to the Risk Appetite Framework, and therefore you should have committees to monitor the various triggers, linked with capital planning.
How might firms best plan for TLAC & MREL?
Capital plan usually look 3 years ahead, and they plan future issuances of all form of capital (CET1, AT1, T2, SNP). They are based on planned evolution of risk weighted assets, and all foreseeable event that impact capital ratios (M&A, IFRS 9, etc), including the renewal of subordinated debt. In this process, because subordinated debt is very costly, a strong attention should be paid to the evolution of the cost structure of subordinated liabilities, which in return has an impact on the capacity to generate CET1. A deep iterative analysis is very useful. It can be quit efficient to remove costly debt in order to replace it with less costly new issues, either because conditions of issuance are better, or because with the building of strong CET1 capital ratio some costly layers of subordinated debt can be replaced with less junior debt at a preferential cost. Some operations of Liability management can also be used to improve the cost efficiency of the capital structure more rapidly.
Finally, what challenges do you foresee in the future? And have you got any advice for your peers on how to best handle them?
When considering a horizon larger than 3 years, you will have to consider the impact of future regulatory changes that may have a strong and uncertain impact such as CRR2, CRD5, BRRD2 and the most important Basel 4 transposition. In this case, some assets may experience a significant change in risk weights, either directly through a change of IRB risk weights (because of the introduction of input floors), a change in the methodology of calculation, or indirectly through the introduction of the output floor based on the standard measure. Considering the newly published Basel 4 text, several retail asset classes will experience a sharp increase of their capital requirement: real estate, credit cards, revolving lines, overdrafts will significantly be penalized by the new Basel text. This will be particularly the case in countries where those assets are of good quality, with sometimes low defaults (or less than what is implied by the standard risk weight). It will not be efficient to ask the client for a margin that pays for the remuneration of CET1 capital based on the output floor requirement, AT1 for the leverage ratio, T2 and SNP for the MREL/ TLAC requirement. In all the situations where the underlying economic risk is much lower than the cost of prudential requirements, it will most likely be more efficient to sell the asset (or pools of assets) directly or through a cash securitization in order to finance it directly through capital markets and remove it from the bank’s balance sheet. In such case the cost of the securitization will be align with the economic cost and the business will favorably evolve toward a fees-based model, with servicing commissions rather than the usual financing through bank’s balance sheet.
The best way to prepare for this evolution is to perform this performance analysis on those assets, and -when necessary- to begin building all the warehouse necessary to start the industrialization of such a selective deconsolidation process.
Frederic will also be speaking at the 7th Annual Risk EMEA Summit. Will you be joining us?…